Partnering with a private equity firm is all about learning. But before learning virtuous growth cycles, which can be mastered by any small-business owner regardless of industry or location, let’s start with learning basic private equity lingo.
When considering selling your small business to private equity, it’s helpful to have an understanding of frequently used terms to discuss details of the partnership. Below are 10 terms to become familiar with before partnering with private equity:
Assets are items purchased exclusively for business use. Fixed assets are physical investments such as land, furniture, computers and machinery; they’re essential to operations but don’t directly provide cash flow. Current assets are resources that will be used up or converted into cash within one year, like accounts receivable, inventory and stock. These assets indicate how much money a business has available to fund growth without external support.
Liabilities are money or services that your small business owes to another person or entity. Short-term liabilities must be fulfilled within one calendar or operating year—such as accounts payable, payroll taxes, and temporary debt. Long-term liabilities are not due within the calendar year. Although they can take years to pay off, long-term liabilities can also play a big role in starting and growing your business. In general, a profitable small business has more assets than liabilities.
EBITDA – or earnings before interest, tax, depreciation and amortization – is an indicator commonly used by prospective buyers or investors to measure a company’s financial performance. It’s calculated by adding the non-cash expenses of depreciation and amortization back to a company’s operating income using the formula: EBITDA = Operating Profit (EBIT) + Depreciation (D) + Amortization (A). When appealing to potential investors, using EBITDA helps balance the scales by focusing on operating profitability as a singular measure of performance.
Active Portfolio Companies
Active portfolio companies are businesses that have been acquired by private equity and are progressing through the growth stage. Evolution is currently managing the growth of nine active portfolio companies using our Five Fundamentals. Every private equity firm employs different growth practices to scale its active portfolio companies.
Realized Portfolio Companies
Realized portfolio companies are enjoying the benefits of their achieved potential. Evolution has helped five entrepreneurially run small businesses lay the foundation for long-term profitable growth and guided them through the exit process. The goal of partnering with private equity is to transform and scale your business into a realized portfolio company.
A private equity fund’s individual partners are also known as its general partners. The general partners manage the fund, including selecting the investments within the fund portfolio. The general partners bear the majority of risk because their personal assets are subject to liquidation.
Limited partners are typically high net worth individuals or institutions who make a capital commitment to a fund. A limited partner earns a return on his or her investment that varies depending on the terms of the partnership, but the IRS considers this passive income since they don’t play an active role in managing the business.
When a private equity fund exceeds a specified return, the general partner receives a share of the profits as compensation (or incentive) for building business value. Carried interest is the primary source of income for general partners and works to align interests. Typically, carried interest amounts to around 20-25% of the fund’s profits.
To cover the costs of managing the investments, an annual fee, typically around 2% of the fund’s assets, is charged. This is the only compensation a general partner is guaranteed, given they have to deliver significant results in order to receive carried interest.
A distribution waterfall is a customized hierarchy establishing the order in which general and limited partners receive their initial investments and preferred returns from the private equity fund. Typically, the distribution waterfall is structured so limited partners are paid before the general partners are entitled to any profits to ensure confidence in the investment’s potential.
Looking to learn more about partnering with private equity?
Contact Evolution Capital Partners at (216) 593-0402 or online.